Over the last two years, tax-exempt colleges and universities have become targets of increased scrutiny by the Secretary of Education, the Internal Revenue Service ("IRS") and the Senate Finance Committee. With the looming budget crisis and an ever-increasing deficit, regulators are taking a hard look at whether these institutions are providing the public benefits commensurate with the tax breaks they receive as a result of their tax-exempt status. As with other sectors in the nonprofit area, such increased scrutiny will most likely lead to audits, investigations, and possible legislative action.

This article addresses the recent actions taken by regulators, lessons learned from other nonprofit sectors that have faced similar increased scrutiny, and steps necessary to reduce the risk of audit and investigation.

Recent Actions

In September 2006, the U.S. Secretary of Education's Commission on the Future of Higher Education issued a report that called for urgent reform in higher education, including expanding access to colleges and universities, boosting affordability, streamlining the financial aid system, improving the quality of education, increasing transparency and accountability, and cultivating a culture of innovation and quality improvement.

Beginning in December 2006, the Senate Finance Committee took a number of actions that placed higher education institutions under the microscope. In a hearing titled "Report Card on Tax Exemptions and Incentives for Higher Education: Pass, Fail, or Need Improvement?," the Senate Finance Committee sought information on the types of activities that colleges and universities undertook in an effort to determine whether their tax-exempt status was warranted.

Nearly a year later, the Senate Finance Committee issued a questionnaire regarding endowments to 136 of the nation's wealthiest colleges and universities whose endowments were in excess of $500 million. The questionnaire had only 11 questions, which requested information regarding tuition and fees, financial aid, and detailed information regarding endowments, including how they are managed and the fees paid for such management.

This past September, Sen. Charles Grassley (R-Iowa) and Rep. Peter Welch (D-Vermont) convened a roundtable discussion titled, "Maximizing the Use of Endowment Funds and Making Higher Education More Affordable." Although no specific legislative proposals have resulted from these actions, Grassley has expressed an interest in mandating that wealthier colleges pay out 5 percent of their endowments.

The IRS also jumped on the higher education bandwagon by distributing a 33-page questionnaire to approximately 400 public and private four-year institutions across the country. The questionnaire requests information about the recipient's unrelated business income ("UBI") activities, endowments, and executive compensation. In addition, the questionnaire seeks information regarding the organization's operational activities, financial status, policies, affiliates and employees.

More specifically, the questionnaire focuses on the following topics:

- Endowment Funds: Institutions are required to provide information regarding the asset allocation, management, and distribution of endowment funds. Specifically, the IRS appears to be focusing in on the Board's investment policy and oversight exercised by the investment committee, the approval and employment of an outside party/consultant to manage the institutions endowment investments, and the process by which the organization compensates such party or consultant. Significantly, the questionnaire also requests information on an issue repeatedly raised by the Senate Finance Committee: what is the average amount of endowment funds per full-time equivalent student?

- Unrelated Business Income: Colleges and universities are required to disclose detailed information with respect to 47 activities that, in the IRS's view, are likely to generate UBI, such

as advertising, sponsorships, food services, credit card/affinity agreements, and facility rentals. Specifically, institutions must disclose how they report revenues and expenses from such activities; determine whether an activity is exempt or taxable (including whether they relied on the advice of independent accounting or legal professionals); and manage taxable activities. Institutions are required to provide additional information where these activities are conducted through a joint venture or are managed by an entity that is not exempt under Section 501(c)(3) of the Internal Revenue Code ("IRC").

- Executive Compensation and Fringe Benefits: As with the newly amended Form 990, the IRS requests more detailed information concerning the Board of Trustees' role in setting and approving the compensation of the six highest paid officers, directors, trustees, and key employees, and the five highest paid employees (including coaches). Notably, the questionnaires seeks information concerning supplemental athletic-related income as well as 34 specific types of fringe benefits, including controversial items such as vacation homes, spousal travel, and loans to officers and directors.

Although the IRS states that the questionnaire is voluntary, failure to complete may well result in an audit. Conversely, an institution's response to the questionnaire may also result in an audit of the institution. Two years ago, after the distribution of a similar questionnaire to tax-exempt hospitals, the IRS audited approximately 64 percent of the questionnaire recipients.

Lessons Learned

Instructive are the legislative proposals and reforms that have occurred in the tax-exempt health care and credit counseling industries. Much like the pattern we see with colleges and universities, both of these industries became the subject of scrutiny by Congress, the IRS, and other regulatory agencies.

In June 2006, tax-exempt hospitals were requested to complete questionnaires by the IRS, which attempted to ferret out their treatment of people without insurance, the types of community benefits that they provide, and the amount of charity care that they offer. In 2007, the Senate Finance Committee released a white paper that proposed legislative reform with respect to the tax-exempt status of hospitals by imposing more stringent requirements on IRC Section 501(c)(3) hospitals, such as mandating that a certain percentage of the hospital's budget must be devoted to providing charity care, and introducing the concept of IRC Section 501(c)(4) hospitals. While these reform measures have not yet resulted in legislation, regulators continue to aggressively scrutinize tax-exempt hospitals by requesting detailed information of tax-exempt hospitals under the new Form 990 Schedule H, and continuing to investigate and audit tax-exempt hospitals.

Similarly, legislative reform in the credit-counseling arena occurred on the heels of aggressive scrutiny by the IRS, the Senate Finance Committee, and other regulatory agencies. After the credit counseling industry was the target of an IRS questionnaire, numerous audits, and a Senate Finance Committee white paper recommending legislative reform, Congress enacted legislation that altered the landscape of tax-exempt credit counseling agencies. In August 2006, Congress added IRC Section 501(q), which established new standards and requirements for credit counseling agencies to qualify for recognition of federal tax-exempt status under IRC Sections 501(c)(3) and 501(c)(4) that were in addition to, and more stringent than, existing tax exemption requirements. The additional requirements resulted in the inability of certain credit counseling agencies to maintain their IRC Section 501(c)(3) status.

While both IRC Sections 501(c)(3) and 501(c)(4) organizations are exempt from federal income tax, Section 501(c)(3) organizations receive the additional benefits of being able to issue tax-exempt bonds and receive contributions that are deductible under IRC Section 170, among other benefits. Because higher education institutions rely heavily on charitable fundraising to assist with operations and programs, and tax-exempt bonds to help develop and maintain their facilities, any proposal that would potentially reclassify a higher education institution as exempt under IRC Section 501(c)(4) could result in significant financial hardship.

Tips to Avoid a Prolonged Audit and Investigation

In responding to the IRS questionnaire, we suggest the following:

- Use the CPA who has worked with the institution to prepare its IRS Forms 990 to assist the institution in responding to the IRS questionnaire, along with your attorney.

- Have the institution's CPA work with the audit committee/finance committee (or in the case of a smaller institution, the board member with a financial background), investment advisors, the board, staff, and legal counsel to timely complete the questionnaire.

- Answer the questions truthfully and thoroughly. Blanks and half-answers will be red flags.

- Be proactive. The questionnaire highlights specific governance issues and internal controls that the IRS, as well as other regulators, has consistently emphasized. Nothing shortens an investigation more than when a target suggests and/or implements reforms on its own. For instance, if the institution does not have a conflict of interest and/or investment policy, adopt one.

- Be transparent and document your compensation decisions. Going forward, when hiring an investment advisor or reviewing compensation arrangements for your officers and key employees, make sure that your compensation committee reviews comparable packages in the industry and documents such reviews. In addition, ensure that the board of trustees/directors reviews and approves these compensation arrangements, and documents such approval in the minutes of the board meetings.

The audit and investigation process is long and arduous, and has the potential of resulting in the loss of tax-exempt status, coupled with an assessment for taxes, penalties and interest owed, as well as unwanted publicity which will adversely impact fundraising and survival in these difficult times.

Sally G. Blinken is a partner in Venable LLP’s Commercial Litigation and Nonprofit Practice Group. Prior to joining the firm, Blinken worked for seven years as a New York State Assistant Attorney General, serving in the Public Integrity and Charities Bureau. Ann Thomas is an associate in Venable’s Association and Nonprofit Organizations Practice Group.